Debt Crowdfunding: Everything You Need to Know

Updated: May 24


There are many ways for businesses to raise money these days and crowdfunding is fast becoming a great option for business owners. What's great about this is you can raise both debt and equity through crowdfunding.


So what is a crowdfunding loan? Debt crowdfunding is a way for businesses to borrow money and it works just like a business loan. The difference is that you'll be dealing with a large pool of investors who contribute small amounts of money instead of a single institution lending the entire amount.


Debt based crowdfunding is an alternative way for small businesses and startups to raise cash. However, there are many nuances that you need to be aware of before opting for it.


A lot of these have to do with the way crowdfunding itself works.


What is Crowdfunding?


Before getting into the specifics of debt crowdfunding, let's take a step back and understand what crowdfunding is.


As the name suggests, this is a method by which you raise funds from a crowd or a large number of people. The process itself is pretty simple.


You create a campaign on websites such as Kickstarter or Indiegogo and tell people why they need to give you money. Tell your backers what they'll get in return?


The things you can offer them depend on the type of crowdfunding you're carrying out.


The Types of Crowdfunding


The most common forms of crowdfunding are (in order):

  1. Rewards based

  2. Donation based

  3. Equity based

  4. Debt based

Rewards based campaigns offer perks to their backers such as the ability to pre-order the product or some other gift in return for their money.


Donation based campaigns are used by individuals and nonprofits to raise money for charitable causes. As such, there is nothing that is physically returned here. However, larger charities conduct P2P fundraising which often culminates in some event that attracts participants.


Equity based campaigns are used by businesses, be they startups or small businesses. Startups use this route as an alternative to finding angel investing or going through the venture capital investing process.


A large number of equity based crowdfunding platforms provide access primarily to registered investors due to the high risk involved. After all, they'll be investing in companies that have almost no track record and there's no guarantee of success.


However, it is possible for non accredited investors to take part in the process as well.


While there are many advantages to raising money through this method, there are a few drawbacks. These drawbacks are what make debt based crowdfunding attractive for companies.


Debt Versus Equity


Company owners are hesitant to give up equity in their businesses and with good reason. While debt financing puts a burden on the balance sheet and cash flows, it can result in greater profits if executed well.


It is for this reason that debt based crowdfunding exists. What's more, it isn't just companies who can source funds from this alternative method.


Individuals can do so as well.


Debt based crowdfunding works in almost the same way as traditional loan financing does. In the traditional method, you go to the bank and apply for a loan.


If you qualify, the loan officer gives you a sum of money and you need to pay it back with interest over a certain period of time. The payment frequency is typically on a monthly basis.


The great thing about debt based crowdfunding is that borrowers are never in any doubt as to what they need to provide their backers in return.


All they need to do is make payments on time and they'll be just fine. This isn't the case with rewards based or equity based campaigns where the terms of the backing have a lot of wiggle room in them.


Equity based deals are negotiated between the investor and the company and these can include virtually any number of clauses.


Rewards based campaigns often give their backers sleepless nights and some of them even end up suing the creators of the campaign due to a lack of delivery or expectations not being met.


All of this means that small businesses are especially well served by opting for debt based crowdfunding. Let's take a deeper look now at how the process works.


How to Borrow Money From Crowdfunding


Debt crowdfunding is best suited for the following entities:

  1. Startups

  2. Small businesses

  3. Individuals

Startups face many challenges as they grow and debt crowdfunding is a great way for them to raise money without giving up equity.


The flip side is that they will struggle to raise debt since investors will want to see some sort of a track record before investing in a company. Debt investors tend to be a bit more conservative and a startup investment is anything but!


Types of Instruments Offered by Startups and Small Businesses


The types of debt instruments your company can offer depends on the platform itself. A few platforms such as StartEngine enable companies to issue both debt as well as convertible notes.


The question is whether any investors would be willing to invest in such debt. Most angel investors prefer equity investment and on such platforms, equity crowdfunding is what brings in the traffic.


Convertible notes tend to be complicated investments and the simpler your offer is, the more money you'll raise.


This is why debt or bonds are a far easier way to raise money for businesses. Keep in mind that you'll still need to create a great pitch that your potential investors can understand!


From an investor's perspective, investing in convertible or regular debt issued through a crowdfunding platform can be a great way to get in on a company before it makes it big. The flip side is that the risks are a lot higher.


One of the biggest risks, aside from the company simply not making it, is the lack of liquidity. You will need to remain invested in the company for at least five or more years in order to realize any sort of a return.


While wealthy individuals have multiple cash flows that can help them tide over this period, you need to check whether you can handle this situation.


Crowdfunding platforms claim that the securities they issue can be traded in a secondary market and this is technically true. However, given that the number of investors are low, you're unlikely to receive a great price for it.


All in all, investors should stick to safe investing principles and only invest money they can afford to lose.


Coming back to the debtor's side of the equation, you need to assess whether a crowdfunded option is really better than traditional fundraising avenues. You might find that the average investor is less patient than a professional one.


You'll learn more about the disadvantages of this fundraising method later in the article. For now, let's examine how the process works.


There are a few simple steps that you can follow to raise money from crowdfunding whether you're an individual or a small business.


Step One - Determine Your Needs


The first step is to determine how much money you actually need. When it comes to crowdfunding, it an be easy to think that the money you're going to receive is free.


This is especially the case when individuals try to borrow money. After all, you're receiving money through a platform and not a serious sounding institution such as bank. People think they can slack a little bit when it comes to repayment.


Nothing could be further from the truth!


P2P lending platforms, which are the ones who facilitate debt based crowdfunding, go to great lengths to make their services attractive to investors.


This means they will package your loan as part of different levels of guarantees. If your loan happens to fall into a payment guaranteed bracket, then you can bet that there will be negative consequences.


Individuals in the United States will face a reduction in the credit scores and this affects their ability to borrow in the future.


As for companies, they can be sued in court since legal entities are not due the same protections as individuals are.


So be very careful when figuring out how much you need to raise since the repercussions are real!


Step Two - Prepare


The key to raise money successfully is to treat the entire process as if you're applying for a loan with a traditional lender.


This means you will need to prepare and present all relevant financial documents to the lending platform. The platform will conduct due diligence on your credit worthiness.


Based on this assessment, you will be offered loan terms along with the the relevant APR. In the background, the platform will categorize you into a bucket that classifies your desirability as someone to lend money to.


They do this to enable investors to be able to construct portfolios across different risk exposure levels. If you happen to be someone who has a poor credit score, you will most likely be placed into a category where the investor will earn a high interest rate but their principal will be deemed to be at risk.


Your interest payments are the investor's return on their loan. The platform, which is a facilitator in this case, will simply deduct a fee and make some money whether you repay the entire loan or not.


Some platforms offer their investors guaranteed payments on their principal. However, such loans are extended only to debtors who prove to be credit worthy.


Step Three- Make Payments


Once you've been approved and have accepted the terms of the loan, the platform will list you on their pages and will market you as someone to be invested in. They will also bundle you into packages according to investors' desired risk levels.


As people lend you money, the platform aggregates it and once the goal is hit, you'll be sent the money. Depending on the platform you may or may not have to write a pitch.


The oldest platform in this space, Prosper, does all the work for you. However, some of the newer platforms stick to the crowdfunding approach a bit more and you might have to provide a pitch.


Once you receive the money, you'll need to make payments according to the schedule you agreed to.


That's all there is to it!


Advantages


So, are P2P lending and crowdfunding sites worth it when it comes to raising debt? It really depends on your individual situation.


People who have low credit scores and struggle to borrow money from traditional lenders will find that online platforms far more lenient.


Typically, the interest rate you'll pay through these channels are far lower than what a credit card might charge you. Keep in mind that some credit cards offer excellent promotional rates so you might be able to score a great deal on those.


Generally speaking though, businesses and individuals will find crowdfunded debt to be cheaper and easier to service.


If you're someone who relies on cash advances or other payday lenders then crowdfunded debt is your best choice. If you're someone who has middling to decent debt, then it might not be the best deal for you.


Some platforms will offer you cheaper interest rates and easier terms but this isn't an automatic thing. It really varies from one platform to the next.


When compared to equity based crowdfunding, the advantages are obvious for small businesses. As long as you manage to service the debt, you'll be able to build value in your business.


Given that the cost of this debt is cheaper, many small businesses find that debt based crowdfunding is a win-win situation for them. The red tape is a lot lower and you won't have to wait for too long to receive a decision.


On average, processing time takes around three days which is far lower than the time traditional lenders take.


Anecdotal evidence suggests that you stand a greater chance of being funded with P2P lending when compared to a traditional lender. This is because when you apply to a bank, or any traditional lending institution, a single loan officer is the one who makes the call.


With crowdfunded debt, your credit worthiness is being determined by a large number of people and thus, you're chances of being considered credit worthy are far higher.


There are many advantages as you can see. However, it would be remiss to not consider the disadvantages of crowdfunded debt.


Disadvantages


A lot of the disadvantages lie on the investor's side to be honest. Unlike with equity based crowdfunding, you're not getting a slice of the company's pie.


Furthermore, you cannot rely on anyone else to evaluate the company or the individual's financial state. The platforms make your job a bit easier in this regard by providing predesigned portfolios.


However, these are hardly a guarantee of payment. The worst part is that while you are lending money to another entity, you are not considered a traditional lender.


Therefore, you'll have to wait in line with everyone else in case a default sparks an auction of the debtor's assets.


Compare this to the returns and the greater levels of security you would receive if you were to invest in publicly traded corporate bonds. In the case of a bond defaulting, you're first in line to automatically receive any proceeds from the auction.


What's more, you're investing in a far larger entity that has fully audited accounts. The odds of a large public entity committing accounting fraud is far lesser than a smaller private entity doing the same thing.


Investors typically earn higher levels of returns on their money but the risk is a lot higher so this is something they really need to consider before placing their money in P2P platforms.


From the borrower's perspective, you will need to take care of the added cash burden. Also keep in mind that online platforms are not open to renegotiating your debt burden or even consolidating it with your other debt.


If you receive onerous terms, it might be better to simply decline them instead of borrowing money. Given the lack of exit options from this debt, you need to think long and hard before committing to it.


Companies need to keep in mind that their investors are likely not going to be as sophisticated as what they might find through traditional avenues.


While most investors understand that their money will be locked up for at least five to 10 years, quite a few of them will probably invest more than they can truly afford.


This means you might have to provide constant updates aimed at assuring investors that their money is being used well.


Some entrepreneurs fare better with sophisticated investors behind their back so it's up to you to assess which type of an environment is better suited for you.


Regulations to be Aware of


What do governments say about raising debt through crowdfunding platforms?


In the case of an individual borrowing money through a platform, there are strict regulatory frameworks in place that protect both investors as well as debtors.


The platform is required to register as a lender and needs to conform to necessary guidelines. In the United States, the Securities and Exchange Commission (SEC), the Federal Trade Commission (FTC) and Consumer Financial Protection Bureau assume oversight over the entire process.


P2P lending in the U.K is overseen by the Financial Conduct Authority and the FCA adopts a consultative approach towards the industry, in contrast to the stringent approach that the American authorities take.


The other notable jurisdictions with regard to debt crowdfunding are China and Japan. In fact, China is one of the most active markets with close to $61.50 billion raised in 2016!


Regulation varies across the board. This much is clear: In the United States, regulatory authorities are quite strict and as a result, there is a lot of transparency in the system. Investors and borrowers alike can use the system with a high degree of confidence.


The SEC's stipulations with regards to equity crowdfunding apply to debt crowdfunding as well. There are three categories that apply to investors:

  1. Regulation A+

  2. Regulation CF

  3. Regulation D

Regulation A+ or Reg A+ is offered to both accredited and non accredited investors. This means you don't need to be a millionaire to invest in such offers.


Reg CF offerings are also open to non accredited investors. The difference is that investors can contribute only up to $1 million to the company. With Reg A+, companies can raise up to $50 million with additional reporting requirements.


Reg D investments are available to accredited investors only.


Another point to be aware of is that non accredited investors can only contribute an amount less than five percent of their yearly income towards all crowdfunding debt investment. The SEC's investor bulletin has the latest information in this regard.


Conclusion


Debt crowdfunding is a great way for individuals and companies to raise money. The process is best treated as if you were borrowing money from a traditional lender.


Investors need to be aware of the fact that these investments are risky. From a company's perspective, while debt crowdfunding offers many advantages, there are a few disadvantages you need to keep in mind as well.


The key is to understand your requirements and borrow sensibly.


Happy fundraising!